Problem 3:

Consider a European call with an exercise price of 50 on a stock priced at 60. The stock can go up by 15 percent or down by 20 percent in each of two binomial periods. The risk-free rate is 10 percent. (You can borrow any additional funds required at the risk-free rate, and any excess funds should be invested at the risk-free rate.)

A. Determine the price of the option today.

B. Then construct a risk-free hedge of long stock and short option.

C. At each point in the binomial tree, show the composition and value of the hedge portfolio and

demonstrate that the return is the same as the risk-free rate.

D. Onanyrevisionstothehedgeportfolio,makethetransactions(buyingorselling)instockand

not options.